Markets to Fed: Slow Down
The Fed last raised rates on September 26th and stocks have been falling ever since as the chart below shows. Gains in large cap stocks have been largely erased for the year, international developed markets are meaningfully lower for the year, EM is down significantly, and only NASDAQ holds on to gains that are notable. While yesterday’s recovery in equity markets is encouraging, we believe the markets are telling the Fed it’s time to slow down the pace of rate hikes, and to drop the hawkish language.The TIPS market is confirming that the Fed’s hawkish language and pace of tightening may be more than equity markets, and a stable rate of inflation, can sustain. A break below 2% inflation expectations would be of concern. Market expectations of inflation, as measured by the 10-year TIPS breakeven, made its most recent peak just days after the Fed meeting – and like stocks has been trending steadily lower for the month of October. Given global debt levels, the world cannot afford a return of disinflation, let alone, deflation. Inflation expectations are now moving in the wrong direction for global economic and financial market stability. To make matters worse, the US dollar is also moving in the wrong direction – higher in value. In the weeks before the late September Fed meeting, the US dollar was falling and began to test the bottom of its recent trading range (see chart below). This helped support risk assets in the second half of September. The Fed tightening on 9/26 combined with hawkish language, propelled the US dollar back to the top of its trading range. This upward move in the US dollar has been a meaningful contributor to risk-off behavior in the markets. If the Fed remains on its current tightening course, and maintains a hawkish posture, the probability of a continued dollar rally increases and the likelihood of a more meaningful risk-off movement grows. The markets are now telling the Fed to change pace, will the Fed listen?
Canaries in coal mines are very valuable at times like this: the Chinese Yuan (CNY) is a pretty good indicator of whether or not this correction is a just a panic or perhaps the beginning of something larger. So far, the CNY has remained under 7; a key technical level representing China’s commitment to a stable currency (after a rapid depreciation) despite talk of tariffs, trade wars, and US Warships in the Taiwan Straits. If CNY moves meaningfully beyond 7, a new high, this would likely signal that instability was spreading more deeply and that China was responding with currency depreciation of an even more aggressive kind. Yesterday’s market events increase the probability of Fed-related tweets originating from the White House, and beyond.
S&P 500
US DOLLAR
10 YEAR TREASURY
CHINESE YUAN
Source: Bloomberg. Data accessed on 10/23/2018
Jonathan E. Lewis, Chief Investment Officer
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